A 401(k) plan is an employer-sponsored retirement savings plan. Contributions are made with earnings on a pretax basis and the money accumulated in the account is allowed to grow tax-free. The money is taxed when it is withdrawn, however, and early withdrawal from a 401(k) before the age of 59½ will incur a tax penalty.
- Taking an early withdrawal from your 401(k) should only be done as a last resort.
- If you are under age 59½, in most cases you will incur a 10% early withdrawal penalty and have to pay taxes on the amount taken.
- Under certain limited circumstances, a hardship withdrawal without penalty, though still subject to taxes, is permitted.
Understanding Early Withdrawal From a 401(k)
The method and process of withdrawing money from your 401(k) will depend on your employer and the type of withdrawal you choose. Withdrawing money early from your 401(k) can carry serious financial penalties, so the decision should not be made lightly. It's really a last resort.
Not every employer allows early 401(k) withdrawals, so the first thing you need to do is check with your human resources department to see if the option is available. If it is, then you should check the fine print of your plan to determine the type of withdrawals that are allowed or available.
As of 2021, if you are under the age of 59½, a withdrawal from a 401(k) is subject to a 10% early withdrawal penalty. You will also be required to pay normal income taxes on the withdrawn funds. For a $10,000 withdrawal, once all taxes and penalties are paid, you will only receive approximately $6,300. There are some non-penalty options to consider, however.
On March 27, 2020, President Trump signed a $2 trillion coronavirus emergency stimulus bill. It allows those affected by the coronavirus situation a hardship distribution to $100,000 without the 10% penalty those younger than 59½ normally owe. Account owners also have three years to pay the tax owed on withdrawals, instead of owing it in the current year, or they can repay the withdrawal to a 401(k) or IRA plan and avoid owing any tax—even if the amount exceeds the annual contribution limit for that type of account.
Before deciding upon taking an early withdrawal from your 401(k), find out if your plan allows you to take a loan against it, as this allows you to eventually replace the funds. You may also want to consider alternative options for securing financing that could hurt you less in the long run, such as a small personal loan.
The 401(k) Loan Option
A better option is a 401(k) loan. Instead of losing a portion of your investment account forever—as you would with a withdrawal—a loan allows you to replace the money through payments deducted from your paycheck. You’ll have to check if your plan offers loans, as well as if you’re eligible.
The Hardship Withdrawal Option
A hardship withdrawal can be taken without a penalty. For example, taking out money to help with economic hardship, pay college tuition, or fund a down payment for a first home are all withdrawals that are not subject to penalties, though you still will have to pay income tax at your regular tax rate. You may also withdraw up to $5,000 without penalty to deal with a birth or adoption under the terms of the SECURE Act of 2019.
A hardship withdrawal from a participant’s elective deferral account can only be made if the distribution meets two conditions.
- It's due to an immediate and heavy financial need.
- It's limited to the amount necessary to satisfy that financial need.
In some cases, if you left your employer in or after the year in which you turned 55, you may not be subject to the 10% early withdrawal penalty.
Once you have determined your eligibility and the type of withdrawal, you will need to fill out the necessary paperwork and provide the requested documents. The paperwork and documents will vary depending on your employer and the reason for the withdrawal, but once all the paperwork has been submitted, you will receive a check for the requested funds—one hopes without having to pay the 10% penalty.
Substantally Equal Period Payments (SEPP)
Substantially equal period payments (SEPP) may be another option for withdrawing funds without paying the early distribution penalty. SEPP withdrawals are not permitted under a qualified retirement plan if you are still working for your employer. However, if the funds are coming from an IRA, you may start SEPP withdrawals at any time.
SEPP withdrawals are not the best idea if your financial need is short term. Once starting SEPP payments, you must continue for a minimum of five years or until you reach the age of 59½, whichever comes later. Otherwise, the 10% early penalty still applies, and you will owe interest on the deferred penalties from prior tax years. There is an exception to this rule for taxpayers who die (for beneficiary withdrawals) or become permanently disabled.
SEPP must be calculated using one of three IRS-approved methods: fixed amortization, fixed annuitization, or required minimum distribution. Each method witll calculate different withdrawal amounts, so choose the one that is best for your financial needs.
For this method, the annual payment will be the same each year. The payment is calculated using a chosen life expectancy table and a chosen interest rate. The annual amount calculated in the first distribution year is then used each subsequent year of SEPP withdrawals.
Fixed Annuitization Method
This method is similar to fixed amortization in that the annual amount is the same each year. The sum is determined by dividing the retirement account balance by an annuity factor equal to the present value of an annuity of $1 per year. The annuity factor is derived using an IRS-provided mortality table and a chosen interest rate, and it is based on the single life expectancy of the taxpayer alone.
Required Minimum Distribution
For this method, the annual payment for each year is determined by dividing the current account balance by the life expectancy factor of the taxpayer. The annual withdrawal amount must be recalculated each year with the new account balance and, as a result, changes from year to year. The life expectancy table chosen in the first year must continue to be used each following year. This method takes into account market fluctuations, which impact the account's balance.
Early Withdrawal From a 401(k) FAQs
Can You Withdraw From a 401(k) Early?
Yes, but there may be financial consequences to doing so.
Can You Withdraw From a 401(k) Without Penalty?
Yes, for economic hardship, to pay college tuition, or to put money down for a first home. You can withdraw up to $5,000 tax-free to cover costs associated with a birth or adoption. Following the March 2020 passage of the COVID-19 focused CARES ACT, it is possible to withdraw up to $100,000 from a 401(k) early without triggering the normal 10% penalty.
How Much Tax Do I Pay on a 401(k) Withdrawal?
You will need to pay normal income taxes on a withdrawal from a 401(k). Due to the passage of the CARES Act, account owners have three years to pay the taxes they owe.
What Qualifies as a Hardship Withdrawal from a 401(k)?
A hardship withdrawal is allowed when an event triggers an immediate and heavy financial need. The amount taken must be used entirely to cover the hardship. In this case, the early withdrawal penalty is waived, but taxes must be paid.
What Are the Pros and Cons of Withdrawal vs. a 401(k) Loan?
A withdrawal is permanent. While you won't have to pay the money back, you will have to pay the taxes right away and possibly a penalty. Additionally, by pulling out money early, you'll miss out on the long-term growth that a larger sum of money in your 401(k) would have yielded. A loan has to be paid back, but on the upside, if it is paid back in a timely manner, you at least won't lose out on long-term growth.